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2006
The Dividend Puzzle: Are Shareholders Entitled to the Residual?
Daniel J.H. Greenwood
Maurice A. Deane School of Law at Hofstra University
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Recommended Citation
Daniel J.H. Greenwood, The Dividend Puzzle: Are Shareholders Entitled to the Residual?, 32 J. Corp. L. 103 (2006) Available at: https://scholarlycommons.law.hofstra.edu/faculty_scholarship/322
Daniel J.H. Greenwood*
ABSTRACT
Everyone knows that shareholders receive dividends because they are entitled to the residual returns of a public corporation. Everyone is wrong.
Using the familiar economic model of the firm, I show that shareholders have no special claim on corporate economic returns. No one has an entitlement to rents in a capitalist system. Shareholders, the purely fungible providers of a purely fungible commodity and a sunk cost, are particularly unlikely to be able to command a share of
economic profits or, indeed, any return at all.
Shareholders do win much of the corporate surplus. But this is not by market right or moral entitlement. Rather, it is the result of a (possibly temporary) ideological victory in a political battle over economic rents. Surprisingly, since corporate law often assumes a conflict between shareholders and top management, shareholder gains flow from the usefulness of the share-centered ideologies in justifying a tremendous shift of corporate wealth from employees to top managers. Burgeoning CEO salaries are part of the same phenomenon as high shareholder returns, not in opposition to it.
Taking the political nature of the corporation seriously will lead to a series of new and important questions. Are current distributions of corporate wealth justifiable, or should corporate governance treat lower-paid employees as citizens instead of subjects?
Why should only one side in a political conflict have the vote, and why per dollar instead of per person? Given undemocratic internal corporate politics, are current levels of deference to corporate autonomy justifiable?
. Daniel J.H. Greenwood, S.J. Quinney Professor of Law, S.J. Quinney College of Law, University of Utah;
J.D. Yale; A.B. Harvard. http://www.law.utah.edu/greenwood. Special thanks to Jill Fisch for convincing me to develop the point, and to Kent Greenfield, Reiner Kraakman, Daniel Medwed, Joe Singer and participants at the Faculty Workshops of Brooklyn Law School, Hofstra University School of Law, New York Law School and St.
John's Law School for helpful comments; the paper is much improved as a result. I am grateful for the financial support of the S.J. Quinney College of Law Summer Research Fund and the time I spent and discussions I had
I. INTRO D UCTION ... 105
II. T HE P RO BLEM ... 109
A. Economic and Accounting Profit Contrasted ... 111
B. Who Owns the Economic Profit? ... 113
C. Who Should Get the Residual? ... 115
1II. THE MARKET MODEL: THE DIVIDEND MYSTERY ... 116
A. Full Competitive Equilibrium ... ... 117
B. The Sunk Costs Problem Generally ... 118
1. Market Pricing at Marginal, Not Average, Cost ... 118
2. G eneral Solutions ... 119
C. Financial Capital as a Sunk Cost ... 120
1. Shareholders Have No Legal/Contractual Right to Distributions ... 121
2. In Competitive Markets, Corporations Cannot Charge for Their Use of Shareholder F unds ... 123
D. The Unsustainable Public Equity Market ... 123
IV. No EXIT: FIDUCIARY DUTY LAW'S FAILURE ... 124
A. Fiduciary Duty: The Interests of the Corporation ... 124
B. The Autonomous Corporation: The Business Judgment Rule ... 127
1. The Business Judgment Rule's Division of Labor ... 128
2. Judicial Deference: Time, Rational Basis Inquiry and the Business Judgm ent R ule ... 129
3. The Poverty of Wealth Maximization: Multiple Ends Under the Business Judgm ent R ule ... 13 1 C. The Red Queen's Jam: The Impossibility of Timing ... 132
D. The Impossibility of Fiduciary Liability: Post-Lochnerism in Corporate Law.. 135
V. BEYOND THE SIMPLE ECONOMIC MODELS: LIFTING ASSUMPTIONS ... 137
A. Competitive Market Solutions-Converting Fixed Costs to Variable Costs ... 137
1. Preconditions to the Rental Solution ... 138
2. Is it Turtles All the Way Down? ... 139
B. Escaping the Equity Capital Sunk Cost Trap Through Leveraged Buyouts ... 140
at the Tanner Humanities Center.
C . M arket Irrationality ... 142
1. The IP O P uzzle ... 143
2. A Sucker a Minute Keeps the Market Healthy, Wealthy and Wise ... 144
D. The Power of the "Market for Corporate Control ... 144
1. Corporations with a Single Shareholder: Quasi-ownership, Political C o n tro l ... 14 5 2. Closely Held Corporations ... 146
3. Public Corporations: The Right to Go Private ... 146
a. The Brief Heyday of Stock Market Control ... 147
b. Return to Normalcy: The Poison Pill and the New Politics of Corporate C ontrol ... 148
4. The Lim its of P ow er ... 150
E. Cynics and Ideologues: Self-Interested Managers and The Metaphors of C orp orate L aw ... 150
1. A tavistic Irrationality ... 151
2. Tag-along Behind Powerful Managers ... 151
3. The Pow er of W ords ... 152
a. The Problem of Managers as Fiduciaries ... 152
b. The Benefits of Share-centeredness to CEOs ... 153
4. Where Shareholder Returns Come From ... 155
V I. T HE SIGNIFICANCE ... . . ... 155
A. The Struggle for Surplus is Political ... 155
B. Making Political Sense of the Corporation's Struggles ... 156
C. Beyond Determinism: Market Pros and Cons ... 158
V II. C O N C LU SION ... 159
I. INTRODUCTION
Everyone knows that shareholders receive dividends because they are entitled to the residual returns of a public corporation. Everyone is wrong.
Corporate law scholars sharply disagree over the merits of the nexus of contract theory, which emphasizes a metaphor of the corporation as a largely contractual moment
in the market;I corporate-finance based views emphasizing that shares and bonds are closely related and often interchangeable;2 an older fiduciary duty based tradition, which emphasizes the obligations of managers to work for their "principals," the shareholders;3 and institutionalist views which emphasize information problems and the bureaucratic functioning of the firm.4 But nearly everyone agrees that the corporation exists to generate wealth for shareholders.5 Both those who claim that shareholders "own" the
1. This view has its locus classicus in Armen A. Alchian & Harold Demsetz, Production, Information Costs, and Economic Organization, 62 AM. ECON. REV. 777, 777 (1972) (contending that firm is a purely voluntary market phenomenon with no elements of coercion or fiat) and Michael C. Jensen & William H.
Meckling, Theory of the Firm: Managerial Behavior, Agency Costs. and Ownership Structure, 3 J. FIN. ECON.
305 (1976) (describing the firm as a nexus of contracts and reduction of agency costs as the central issue). It currently dominates the elite law schools despite criticisms dating back decades. See, e.g., KRAAKMAN ET AL, THE ANATOMY OF CORPORATE LAW (2004) (proclaiming and exemplifying hegemonic dominance of nexus of contracts theory); William W. Bratton, Jr., The "Nexus of Contracts" Corporation: A Critical Appraisal, 74 CORNELL L. REV. 407 (1989) (surveying and criticizing the approach); Arthur Allen Leff, Economic Analysis of Law: Some Realism About Nominalism, 60 VA. L. REV. 451 (1974) (raising basic objections to an economic approach).
2. For introductions to the corporate finance view, see WILLIAM A. KLEIN & JOHN C. COFFEE, JR., BUSINESS ORGANIZATION AND FINANCE: LEGAL AND ECONOMIC PRINCIPLES (9th ed. 2004); RICHARD A.
BREALEY, STEWART C. MYERS & FRANKLIN ALLEN, PRINCIPLES OF CORPORATE FINANCE (8th ed. 2006).
Corporate finance theory emphasizes that the value of a security is dependent on the risk-adjusted present value of future cash flows, regardless of whether the security is legally classified as stock, bond, or even a third-party option contract to which the corporation is not a party. Accordingly, it teaches that both managers and investors should view these various securities as largely interchangeable, despite the different legal roles they represent in the corporation. Like the nexus of contracts view, corporate finance destabilizes the traditionally privileged position of shareholders and thus undercuts the notion that corporations exist only for the benefit of shareholders. See, e.g., Henry T.C. Hu & Bernard Black, The New Vote Buying: Empty Voting and Hidden (Morphable) Ownership, 79 S. CAL. L. REV. 811, 815 (2006) (describing use of standard finance techniques to allow separation of share voting rights from economic consequences of share ownership).
3. This tradition usually traces itself back to ADOLF A. BERLE & GARDINER C. MEANS, THE MODERN CORPORATION AND PRIVATE PROPERTY (LEGAL CLASSICS LIBRARY 1993) (1932), although modem uses of the book seem radically different from the authors' understanding. See Dalia Tsuk, From Pluralism to Individualism: Berle and Means and 20th-Century American Legal Thought, 30 LAW & SOC. INQUIRY 179 (2005). Berle and Means established the key point that shareholders in the modem corporation are better understood as passive investors than as "owners" in the full legal sense. That insight underpins the Federal securities regulatory system they inspired, which is largely based on a consumer protection model with investors in the consumer role. However, in the modem debate, Berle and Means are most important for an almost opposite idea: "the separation of ownership and control." Having established that shareholders in a publicly traded corporation lack the legal and economic characteristics of ownership-control over the asset, rights to make decisions, and ability to appropriate its profits-they then continued to refer to shareholders as owners. See, BERLE & MEANS, supra, at 119. The metaphor of "equitable" ownership, as if the board of directors were trustees for shareholders, id. at 247, has proven to have more staying power than Berle and Means' alternative (and inconsistent) conclusion that modem corporations could no longer be viewed as private property. Id. at 352-59. Some modem writers in the fiduciary duty tradition, following the Dodds side of the great Berle-Dodds debate emphasize that fiduciary duties may run to more than merely shareholders. See, e.g., LAWRENCE E. MITCHELL, CORPORATE IRRESPONSIBILITY (2001). However, the more common version is symbolized by the famous dictum in Dodge v. Ford Motor Co., 170 N.W. 668, 684 (Mich. 1919), "[a] business corporation is organized and carried on primarily for the profit of the stockholders." See infra note 16.
4. See, e.g., HENRY HANSMANN, THE OWNERSHIP OF ENTERPRISE (1996) (describing the corporation as a
"shareholders cooperative"); OLIVER E. WILLIAMSON, ECONOMIC INSTITUTIONS OF CAPITALISM (1985) (emphasizing transaction costs); Margaret M. Blair & Lynn A. Stout, A Team Production Theory of Corporate Law, 85 VA. L. REv. 247 (1999) (describing corporate form as solution to worker's coordination problems).
5. Dodge, 170 N.W. at 668. But see Paramount Commc'ns, Inc. v. Time Inc., 571 A.2d 1140, 1142 (Del.
firm and those who, following the nexus of contract theory, say that "ownership" is meaningless in this context,6 agree that shareholders are entitled to have the firm operated in their interest. Indeed, even when the shareholders are the same people as other firm participants-most corporate shareholders today are institutional investors, which often also hold bonds and may also be fiduciaries for current or past employees at the corporation, its suppliers, its customers or its competitors-courts and theorists alike often assume that the firm should grant the shareholder role primacy. 7
Contrary to conventional wisdom, however, basic economic analysis of the modem public corporation demonstrates that shareholders have no special claim on a corporation's economic retums.8 Economic profits are rents. No one has a pre-legal entitlement to economic rents in a capitalist system.9 Shareholders, the purely fungible providers of a purely fungible commodity, are particularly unlikely to be able to command a share of economic profits. Indeed, since the contribution of shareholders to the firm is a sunk cost, in a competitive market, shareholders are unlikely to earn any return at all. Accordingly, market-based analyses of the firm should conclude that shareholder returns result from a market distortion.
1989) ("[W]e reject the argument that the only corporate threat posed by an all-shares, all-cash tender offer is the possibility of inadequate value."). For academic discussion, see, e.g., Kent Greenfield, New Principles for Corporate Law, 1 HASTINGS BUS. L.J. 87, 87-88 (2005) (summarizing state of the debate); Henry Hansmann &
Reinier Kraakman, The End of History for Corporate Law, 89 GEO. L.J. 439 (2001) (contending that share- centrism has won the debate).
6. Alchian & Demsetz, supra note 1, n.14. For example, note that shareholders need not be considered owners but can be thought of as investors like bondholders. More fundamentally, much of modem corporate finance is based on Miller and Modigliani's insight that, from the perspective of the firm, equity and debt are largely interchangeable, and the firm's value is largely independent of which it uses to finance itself. Merton H.
Miller & Franco Modigliani, Dividend Policy, Growth, and the Valuation of Shares, 34 J. BUS. 411 (1961);
Merton H. Miller, The Modigliani-Miller Propositions After Thirty Years, in THE REVOLUTION IN CORPORATE FINANCE 129, 132-54 (Joel M. Stern and Donald H. Chew, Jr., eds., 2003). If bonds and shares are interchangeable, of course, the "ownership" rights of shareholders must be unimportant. Cf David Ellerman, The Role of Capital in "Capitalist" and in Labor-Managed Firms (Dec. 2004) (unpublished manuscript), available at http://ssm.com/abstract-633722 (noting that economic understanding of the firm as a production function does not imply that "capital" owns the firm in the sense of being the residual claimant). Even the standard Brealey et al. corporate finance textbook, which assumes throughout that managers ought to be maximizing shareholder return, mysteriously states that the firm "should try to minimize the present value of all taxes paid on corporate income .. .includ[ing] personal taxes paid by bondholder and shareholders," as if bondholders had precisely the same status as shareholders. BREALEY ET AL., supra note 2, at 473. They do not explain why tax avoidance should be a firm goal, why firms should view themselves as aliens exempt from responsibilities incumbent on all citizens, or why shareholder and bondholder taxes are different from personal taxes paid by suppliers, customers, or employees; apparently it is self-evident that the firm should consider as its own concern the personal finances of these financial investors, but not other factors of production.
7. Perhaps the most dramatic judicial proclamation of shareholder primacy is Revlon, Inc. v.
MacAndrews & Forbes Holdings, 506 A.2d 173, 182-83 (Del. 1986), in which the court enjoined certain defensive measures in a hostile takeover because they favored bondholders over shareholders, without regard to whether bondholders were helped more than shareholders were hurt, even though the facts made clear that the two groups heavily overlapped and without more detailed information on actual holdings it was impossible to tell whether investors would view their bond or share holdings as more important.
8. See infra Part Il.
9. On the concept of "rents" as used in the public choice and law and economics literature, see, for example, Mark Kelman, On Democracy-Bashing: A Skeptical Look at the Theoretical and "Empirical"
Practice of the Public Choice Movement, 74 VA. L. REV. 199, 227 (1988) (describing rent-seeking, when it is worthy of condemnation, and ambiguities in concept).
Similarly, black-letter legal doctrine makes clear that shareholders have the same legal right to dividends as waiters have to tips: an expectation that is not enforceable in court. Metaphorical claims that shareholders are "owners" suffering from a "separation of ownership and control" or "principals" suffering from "agency costs," or even "trust beneficiaries," conceal but do not overcome the legal reality. Shareholders have political voting rights in the organization, not the rights of an owner of property, a principal in an agency relationship or a beneficiary of a trust.
The implications are clear. Shareholders win some of the corporate surplus not by market right or moral entitlement, but due to a (possibly temporary) ideological victory in a political battle over economic rents. Surprisingly, since conventional wisdom portrays corporate law as a conflict between shareholders and top management, those conflicts are dwarfed by the common interest of the two groups. Shareholder returns are largely the consequence of managers finding the share-centered ideologies useful as an ideological justification for a tremendous shift of corporate wealth from employees to the
CEO/shareholder alliance.
Standard metaphors of the public corporation as a trust, an agency relationship, a nexus of contracts, a piece of property or a person conceal the internal political struggles over corporate surplus and the weakness of shareholder claims to appropriate it. Taking the corporation's political nature seriously, in contrast, leads to a series of new insights and related questions. If the struggle over corporate surplus is a political struggle over economic rents, why should only one side, the shareholders, have the vote? In a democratic society, why should those votes be allocated on a per-dollar basis, instead of a per-person basis? Indeed, to the extent that shareholders are only a role, and market forces make it a limited and narrow role, is it plausible to believe that the stock market is often a reasonable proxy for the public good? Most fundamentally, why should we, the citizens of the United States, allow our major economic actors-which are also among our most important governing institutions-to treat their employees-us-as foreigners and outsiders, denied not only the vote but even a legitimate claim to the surplus they help create?
In the last several decades, virtually all corporate gains from productivity have gone to shareholders and CEOs, while ordinary employee wages have remained flat or declined.10 This system is obviously not well designed to generate employee loyalty to the firm (or the firm productivity that follows): employees not given a fair share of the wealth they help produce are eventually likely to notice, and employees who view themselves as exploited are unlikely to cooperate fully in their exploitation. Nor is the
10. The problem has been noted by many commentators, both inside the large corporate sector of the economy that is my focus here and more generally. See, e.g., Paul Krugman, Feeling No Pain, N.Y. TIMES, Mar. 6, 2006, at A2 1.
Between 1979 and 2003, according to a recent research paper published by the I.R.S., the share of overall income received by the bottom eighty percent of taxpayers fell from fifty percent to barely over forty percent. The main winners from this upward redistribution of income were a tiny, wealthy elite: more than half the income share lost by the bottom eighty percent was gained by just one-fourth of 1 percent of the population, people with incomes of at least $750,000 in 2003.
Id. For a general discussion of the changes in distribution of wealth and income in the United States over the last two generations, see EDWARD N. WOLFF, TOP HEAVY: A STUDY OF THE INCREASING INEQUALITY OF WEALTH IN AMERICA (1995).
rapidly growing gap between the elite and the rest of us healthy for republican democracy: if the rich really are different from the rest of us, the common enterprise of nationhood fails. If shareholders have no special claim to corporate rents, then existing corporate governance is not only dysfunctional but simply unfair.
All is not lost, however. If the share-centered corporation is not the inevitable result of ineluctable economic law, we are free to adopt different corporate governance rules giving other participants more power, making firms both more just and more likely to succeed in their basic wealth-creation task. 1 Allocations of surplus have no efficiency implications. Thus, we need not fear a tradeoff between "efficiency" and justice:
reforming the internal political processes of our corporations to make them better reflect basic democratic values should not lead to loss of wealth. On the contrary, just as democratic political systems more consistently generate wealth than dictatorial ones, expanding corporate democracy should increase the firm's productivity.
II. THE PROBLEM
In the last third of the Nineteenth Century, American law abandoned its earlier understanding that corporations, endowed with special privileges by the legislature, were inherently public in their purposes and quasi-governmental in their operations.12 In the great divide of liberal political theory between state and citizen, public and private, corporations began to be seen as private, less a part of the state than requiring protection from it, more like citizens than their governments. 13 Indeed, by 1886, the Supreme Court was so immersed in this privatized conception that it felt no need to justify granting corporations the rights of human beings under the Fourteenth Amendment; the seminal Santa Clara opinion offers no reasoning whatsoever. 14
11. As an aside, a realistic understanding of the corporate struggle over allocation of surplus suggests that the corporate income tax needs to be rethought. Current tax law presumes that payments to all factors of production, other than shares, are business expenses reducing profits, while all payments to shareholders are made out of profits. A more realistic system might deny deductibility to any payment to an employee that is greater than, say, five times the median wage on the theory that any payment so high is likely to contain profits.
Conversely, it might grant deductibility for dividends paid to shareholders so long as they are less than some reasonable level, such as the three month T-bill rate plus a 3% risk premium, calculated on the actual amount contributed by shareholders (i.e., par value or the original public offering amount). More radically, we might abandon the inherently complex attempt to define "income" for entities and instead shift corporate taxation to a VAT or equivalent.
12. See, e.g., MORTON J. HORWITZ, THE TRANSFORMATION OF AMERICAN LAW, 1780-1860, at 111-14 (1977) (describing the transition from public to private theories of corporation); HERBERT HOVENKAMP, ENTERPRISE AND AMERICAN LAW, 1836-1937, at 13-14 (1991) (describing the transition from mercantilist to classical model of corporation); Daniel J.H. Greenwood, Essential Speech: Why Corporate Speech is not Free, 83 IOWA L. REV. 995 (1998).
13. Cf Gerald E. Frug, The City as a Legal Concept, 93 HARv. L. REv. 1059, 1075-76, 1100-02 (1980) (describing differentiation of municipal from business corporations and classification of former as public, latter as private).
14. Santa Clara County v. S. Pac. R.R., Co., 118 U.S. 394, 409 (1886). See MORTON J. HORWITZ, THE TRANSFORMATION OF AMERICAN LAW, 1870-1960, at 65-109 (1992) (describing Santa Clara's prefiguring of later theories of corporate personality). From Bank of Augusta v. Earle to Pembina, the Supreme Court consistently upheld differential taxes on corporations: corporations were not citizens. Bank of Augusta v. Earle, 38 U.S. (13 Pet.) 519, 587 (1839); Pembina Consol. Silver Mining & Milling Co. v. Pennsylvania, 125 U.S.
181, 187 (1888). From Allgeyer on, however, business corporations are given essentially the same rights against
Similarly, corporate purposes were reconceptualized. Corporations were no longer understood as existing to promote important public projects, but rather to promote the private interests of their particular participants-even though the largest corporations of the period, the railroads, were engaged in an enterprise of extraordinary public importance, were the beneficiaries of massive land grants and other public subsidies, and were collective enterprises of a scale previously unknown to American governments. On the new analysis, this private, self-interested endeavor would be required to serve the public good, if at all, only by means of Adam Smith's invisible hand, not by any conscious public spiritedness or deliberate consideration of the needs of the public. 15 By the turn of the twentieth century, the state generally abandoned the attempt to control corporations through corporate law, instead using external regulatory law, offering them subsidies or otherwise relieving them of the rigors of the market.
In this world of private public corporations aiming for profit, the obvious question arises: which corporate participants will be allowed to benefit from the surplus the firm generates? The most famous answer appears in Dodge v. Ford Motor Co.: "[A] business corporation is organized and carried on primarily for the profit of the shareholders. The powers of the directors are to be employed to that end. The discretion of directors ...
does not extend to a change in the end itself."16
But Dodge is an outlier.17 Since the first of the recognizably modem general business corporation laws at the turn of the century, the basic rule instead has been that corporations choose their own ends and police them internally, with almost no judicial or other state intervention. Modem laws permit corporations to be formed "for any lawful
the government as people, generally without any discussion whatsoever of whether assimilating firms to citizens is appropriate. Allgeyer v. Louisiana, 165 U.S. 578, 589 (1897); see HOVENKAMP, supra note 12, at 47 (discussing cases and transition in legal conceptions of corporation person); Greenwood, supra note 12 (arguing that rights given to corporations often diminish the rights of their participants); Daniel J.H. Greenwood, First Amendment Imperialism, 1999 UTAH L. REV. 659 (discussing expansion of speech rights, asserted by corporations, into doctrinal territory of Lochner-like assertion of "natural" markets); Carl J. Mayer, Personalizing the Impersonal: Corporations and the Bill of Rights, 41 HASTINGS L.J. 577 (1990) (describing cases granting corporations constitutional rights).
15. Adam Smith himself, of course, wrote that corporations would never serve the public good; however, he was working within the older, public, paradigm of corporations. ADAM SMITH, INQUIRY INTO THE NATURE AND CAUSES OF THE WEALTH OF NATIONS 700 (R.H. Campbell & A.S. Skinner eds., Oxford University Press 1976) (Corporations "very seldom succeed[) without an exclusive privilege; and frequently have not succeeded with one. Without an exclusive privilege they have commonly mismanaged the trade. With an exclusive privilege they have both mismanaged and confined it."). Early 19th century Americans frequently shared this distrust of the large corporation. See, e.g., HOVENKAMP, supra note 12, at 23 (describing Jeffersonian hostility
to corporations); JAMES W. HURST, THE LEGITIMACY OF THE BUSINESS CORPORATION IN THE UNITED STATES
30-45 (1970) (describing suspicions of Gouge (1833) and others regarding corporations, echoing Smith almost verbatim).
16. Dodge v. Ford Motor Co., 170 N.W. 668, 685 (Mich. 1919) (ordering board of directors to declare a dividend despite their own views and views of majority shareholder). Although Dodge is perhaps the most extreme judicial statement of the privatized view of the corporation as existing solely for the benefit of its shareholders, the general attitude was, and remains, common. See also ADOLF A. BERLE & GARDINER C.
MEANS, THE MODERN CORPORATION AND PRIVATE PROPERTY 5, 9 (1932) (describing the rise of the modem
"quasi-public" corporation, but perceiving this as a problem because corporations were no longer subject to "the old assumption that the quest for profits will spur the owner of industrial property to its effective use").
17. See, e.g., Blair & Stout, supra note 4, at 301 (describing Dodge as "highly unusual").
purpose." 18 Moreover, governance of the firm virtually is the exclusive province of the board; judicial supervision is limited by the extreme deference to board decision-making embodied in the business judgment rule.19 Thus, in contrast to Dodge's external command, the usual rule stresses the firm's autonomy. The board of directors of a corporation has extraordinary flexibility in determining how to apply any surplus the firm may earn.
A. Economic and Accounting Profit Contrasted
To discuss shareholder returns, it is first necessary to clarify terms. Profit is an ambiguous term. Common accounting understandings confuse two separate issues:
whether the firm is earning a return, on the one hand, and which firm participants are receiving the return, on the other.
A successful firm is one that creates a surplus, by which I mean that it could sell its product for more than it must pay its various inputs. In the standard jargon, this surplus is the "residual" or "economic profit." A firm that is able to produce a product or service which can be sold for more than the market value of the various inputs is a firm that is successfully creating value-what it produces is worth more than what it consumes.20
Economic profit, so defined, is quite different from the more familiar accounting or legal profit bookkeeping concepts. Accounting profit is equal to the sum of properly declared dividends plus so-called retained earnings (referring, roughly speaking, to funds the corporation holds but has not allocated to any corporate participant).2 1 On the other side of the ledger, all payments made to corporate participants, other than dividends, reduce accounting profit. Thus, any amount the firm pays its employees, any amount the firm does not obtain from its customers, and any amount the firm pays its investors in the form of interest, each reduce accounting profits. Dividends, in contrast, are treated as if they were not costs at all.
The accounting view is not a realistic picture of the corporation's economic success from a social perspective. When a firm needs capital to create its product, the price of that capital is a cost just like all other costs. If it earns an accounting profit insufficient to allow it to pay dividends sufficient to attract the capital it needs, it fails just as surely as if
18. REV. MODEL Bus. CORP. ACT § 3.01(a) (1984) (stating "[e]very corporation incorporated under this Act has the purpose of engaging in any lawful business .. ") [hereinafter RMBCA]; cf DEL. CODE ANN. tit. 8,
§ 102 (2006) (voiding prior doctrine regarding limited corporate purposes).
19. Current Delaware law enshrines the principle of directorial supremacy in § 141(a)'s proclamation that
"[t]he business and affairs of every corporation ... shall be managed by or under the direction of a board of directors." DEL. CODE ANN. tit. 8, § 141(a) (2006). The business judgment rule, best understood as a form of judicial deference analogous to judicial deference to agency and legislative decisions, similarly ensures that directors are the primary corporate decision-makers. See Daniel J.H. Greenwood, Beyond the Counter- Majoritarian Difficulty: Judicial Decision-Making in a Polynomic World, 53 RUTGERS L. REV. 781 (2001) (discussing judicial deference in these and other contexts).
20. See infra note 43.
21. Retained earnings do not, however, represent a fund available for payments to shareholders, despite older misunderstandings to that effect. On the one hand, the corporation may choose or market pressures may constrain it to distribute retained earnings to other corporate constituencies in the form of increased payments to other inputs or decreased prices to customers. On the other hand, dividends may be paid out of other sources, including future earnings, economic profit, borrowing, or sales of assets. Indeed, retained earnings do not represent a fund at all. They are not, for example, a synonym for cash on hand or liquid investments.
it is unable to pay market wages or market price for raw materials. Conversely, if a firm is able to sell its product for more than the costs of its inputs, it is successful, even if it pays out that surplus in some form other than dividends.
Economic profit classifies normal (market) returns as a cost to any input, including capital, regardless of legal label or accounting treatment. Similarly, economic profit classifies as profit any payment to any input in excess of the market price necessary to acquire that input, regardless of accounting treatment. Thus, on the economic view, what counts is not the firm's actual payments for inputs but the market cost for those inputs (including the cost of acquiring capital); not the price it actually does receive but the price it could obtain; not what it does with its surplus but the size of the surplus in the first place. On this view, any part of dividends or interest that is necessary to obtain capital on the market is a cost. Any payment above that necessary cost is part of the firm's economic profits (which has been distributed to bondholders or shareholders respectively).
In short, economic profit is a theoretical measure of the surplus available to the corporation to be distributed among its various participants, inputs, patrons or customers, while accounting or legal profit is a formal measure of the funds distributed to shareholders in the form of dividends or classified by the firm as retained earnings. The distinction should be familiar. Before check-the-box taxation, it would have been surprising to see a successful closely held corporation report an accounting profit;
publicly traded corporations often manipulate accounting conventions to the opposite effect.22
In a theoretical fully-competitive market, of course, prices are driven down to costs.
It follows that, as I have defined it, economic profit is a disequilibrium producer's surplus: an imbalance in the market in which price is (or could be, at the seller's option) higher than cost.
When economic profit exists, typically it will be difficult to calculate, because surpluses exist only when markets are less than perfectly competitive, and if a market is imperfect, the market price of inputs and products may be imprecise as well.23
22. See, e.g., Kamin v. Am. Express, 383 N.Y.S.2d 807 (N.Y. Sup. Ct. 1976) (upholding accounting treatment that management believed would improve stock market perceptions of profit, despite consequence of higher income tax obligation). Since the development of the LLC and "check the box" pass-through taxation, closely-held firms generally can elect not to pay entity-level tax without manipulating accounting profit labels.
However, manipulating labels remains important for other reasons. Leveraged buyouts, for example, which pay out surplus in the form of interest, were highly effective in convincing employees to accept a smaller share of corporate surplus: employees who might have protested had the company insisted it needed employee give- backs in order to increase its profits were willing to pitch in to stave off bankruptcy, even when the cash flows were identical transfers of a slice of the corporate pie from employees to capital. Similarly, CEOs of publicly traded companies discovered that stock-option grants allowed them to transfer corporate surplus to themselves with minimum publicity and, until recent reforms, no impact on reported profits.
23. In competitive markets, each input will be priced at (or marginally above) its value in its next most profitable use, and the product should be priced at (or marginally below) the cost of production of the next lowest cost producer. At that level, the firm will have as large a supply of inputs and be able to sell as much of its product as it wishes. A firm earning an economic profit is one that can pay those prices and sell at that price and have something left over; it is more efficient than its competitors. As other firms learn, they should compete away that advantage. However, in less competitive markets, firms may be able to earn economic rents-i.e., sell their product for more than economic costs-for extended periods of time. This Article is concerned with the distribution of those rents or surpluses. In a fully competitive market at equilibrium, there are no surpluses; if
Nonetheless, the concept is essential. Economic profit is the pie that is available for distribution, the fund which can be struggled over, regardless of where it ends up.
B. Who Owns the Economic Profit?
It is fundamental to the very notion of corporate existence that any economic profit or surplus belongs in the first instance to the corporation itself, and not to any of its various participants.24 Accordingly, it is the corporation's board or its delegates, operating as the decision-makers for the institution itself, who decide what to do with this economic surplus and how to classify it for legal purposes.25
Rather than declare a dividend, the board and executives26 may decide to reinvest economic profits-that is, to increase the firm's contractual obligations, thereby distributing the former period's profit to the next period's corporate contractual participants. They may pay it to employees in the form of higher salaries or increased managerial benefits. They may distribute it to creditors by paying debt before it is legally due or in the form of interest on new debt. They may distribute it to customers by reducing sales prices or to suppliers by increasing purchase prices. They may decide to simply retain it in the corporate bank account or other financial investments. Or they may decide to distribute it to shareholders, by means of a dividend, dissolution of the firm or a stock buyback.
If the board chooses to retain the economic surplus in the corporation's name beyond the end of an accounting period or distributes it to shareholders, the economic surplus will become profit in the accounting and legal sense. But nothing forces a board to do that. If it prefers not to have accounting profit, it can simply increase its contractual obligations during the period in which the surplus is eamed.27 In this case, no profit will
any factor of production (including capital) succeeds in demanding more than competitors pay, the firm will be driven out of business.
24. DEL. CODE ANN. tit. 8, § 122 (2006) (granting corporation, inter alia, powers of permanent succession, ownership, contracting, etc.). Individual shareholders have no right to dissolve a corporation or otherwise force the corporation to distribute any of its assets to the shareholder. See, e.g., id. § 275 (dissolution of corporation is by resolution of the board followed by vote of shareholders). In contrast, in a partnership, any partner has the right at any time to demand his or her pro rata share of the partnership assets (including, of course, any surplus from prior periods). See, e.g., UNIF. P'SHIP ACT § 31 (1997) [hereinafter U.P.A.] (granting every partner the right to dissolve the partnership even in contravention of partnership agreement); id. § 38 (granting every partner on dissolution rights to pro rata share of partnership assets, except that wrongfully dissolving partners are not entitled to share in value of goodwill).
25. DEL CODE ANN. tit. 8, § 141 (2006) (business and affairs of every corporation managed by or under direction of its board); id. § 170 (board may declare and pay dividends, subject to certain restrictions); RMBCA
§ 8.01(b) ("all corporate powers shall be exercised by or under the authority of its board"); id. § 6.40(a) (stating that board may authorize distributions to the shareholders, subject to certain restrictions).
26. Hereafter, I will generally refer just to the board-with the understanding that in practice most relevant decisions will be made in the first instance by executives and many may never even be submitted to the board for ratification. For current purposes, the specific allocation of power between board and executives seems unimportant.
27. Precisely the same problem arises in the corporate income tax context. The income tax is levied on profit, defined as revenues less expenses allowable as deductions. Corporations, therefore, may be tempted to reduce their taxable profits (and therefore taxes) by classifying as "expenses" payments greater than those required by the market. Most obviously, a shareholder CEO will minimize taxes by paying economic profit to herself in her CEO role as salary, rather than in her shareholder role as dividends. See, e.g., I.R.C. § 162(a)(1)
ever appear on the corporation's books. Instead, prices will be lower or input costs will be higher than necessary. 28
Legal restrictions on this board discretion are few. Shareholders have a legal right to the surplus only after the board of directors declares a dividend.29 The duty of care requires the board to give due consideration before deciding to act (or not act).30 The duty of loyalty prevents the board from giving away corporate assets without receiving an appropriate quid pro quo.31 Within these broad constraints, boards are free to do what seems right in their eyes.
Even where the duties of care or loyalty might seem to restrict board discretion, however, the business judgment rule severely limits judicial review of board decisions. In effect, courts police only insider deals, in which a dominant shareholder or other insider receives corporate assets on terms not available to others.32 Even then, courts mainly look for secret deals, routinely declining to second-guess the decisions of informed
(2000) (allowing corporate deduction for "reasonable" executive compensation, even when the executive is also a (or the sole) shareholder). In contrast, payments to a partner of a partnership are ordinarily classified as profit, even if the partner contributed time to the partnership. See U.P.A. § 18.
28. For several years, the standard corporate finance text explicitly asserted that "retained earnings are additional capital invested by shareholders, and represent, in effect, a compulsory issue of shares." RICHARD A.
BREALEY & STEWART C. MYERS, PRINCIPLES OF CORPORATE FINANCE 324 (4th ed. 1991); RICHARD A.
BREALEY & STEWART C. MYERS, PRINCIPLES OF CORPORATE FINANCE 364 (5th ed. 1996). Obviously this is not true in any literal sense. Retained earnings result when sales proceeds and other income exceed costs and other expenses; not shareholder contributions or share issuance. Instead, Brealey & Myers mean it metaphorically: as they explain, "a firm which retains $1 million could have paid the cash out as dividends and then sold new common shares to raise the same amount of additional capital." Id. To be sure, a firm could have done that. But money is fungible, and firms can obtain it from many sources. Generally, corporate law allows dividends to be paid out of "surplus," which may be any portion so designated of the net assets of the corporation. See, e.g., DEL. CODE ANN. tit. 8, § 154. In effect, so long as the firm remains solvent, it may pay out any funds it has as dividends. For example, a firm with retained earnings could borrow money and immediately pay it out as dividends, or it could reduce employee pay (or, more easily, fail to increase employee pay to match increases in productivity) and pay that cash out as dividends. On the Brealey & Myers logic-that any money which could have been paid out as dividends should be treated as if it were a shareholder capital contribution-shareholders should be deemed to have contributed these amounts as well! In Brealey & Myers's world, the shareholders magically create all value in the firm, regardless of the contributions of others. Of course, a less shareholder-sympathetic view could use the same logic to reach the opposite conclusion. Thus, the firm could also have paid out its retained earnings or any other available cash as salary, bonuses to suppliers, discounts to customers, or made any other legal use of it, and then borrowed or sold shares to raise the same amount of capital. So, we could just as well say that retained earnings were contributed by employees and represent a compulsory reduction of salary. This shareholder claim to corporate funds is no more than Sophistic spin.
29. See supra notes 25-26; cf RMBCA § 6.40(0 (declaring dividends treated as an unsecured debt to the shareholders at parity with other unsecured debt).
30. Smith v. Van Gorkum, 488 A.2d 858 (Del. 1985); RMBCA § 8.30 (setting out duty of directors to act in good faith and in a manner the director reasonably believes to be in the best interest of the corporation).
31. RMBCA § 8.31 (lifting director's protection against suit for breach of duty of loyalty on, inter alia, showing of lack of objectivity due to a conflict of interest); id. § 8.60 (setting out requirements for actions challenging director's conflicting interest transactions); Cinerama, Inc. v. Technicolor, Inc., 663 A.2d 1156 (Del. 1995) (setting out a procedural test for determining possible breaches of duty of loyalty); In re Wheelabrator Techs., Inc. S'holders Litig., 663 A.2d 1194, 1201-06 (Del. Ch. 1995) (similar).
32. Joy v. North, 692 F.2d 880, 886 (2d Cir. 1982) (defending business judgment rule on ground that judicial abstention promotes risk taking by managers).
independent directors.33 Thus, no American court has yet set any limit to the amount a public corporation's fully informed board may publicly pay its CEO, even in the absence of any evidence that the board had any basis to think the CEO's services could not have been obtained for less.34 As long as the board does not appear to be unduly influenced by the CEO, modem courts do not intervene, even if the firm appears to be giving the bulk of its economic profits to the CEO-just as courts during the unionized age did not intervene when companies appeared to be acting primarily in the interests of unionized employees and mid-level managers, or when companies have adopted as their primary goal promoting their product or even a particular way of doing business.35
In short, the board has legal discretion to treat the economic profits-the residual- in virtually any way it pleases.
C. Who Should Get the Residual?
Nonetheless, commentators and courts routinely ask what the board should do with the corporation's profits. And the answer has seemed obvious to many: profits are rightfully for the shareholders.36
But economic profits are rents, and as a general rule, no one has a moral entitlement to rents. When cooperation creates a surplus in a market economy, normally we assume that the parties are free to bargain for any division of it. If shareholders can win some of the surplus, all power to them. But if they cannot, they have nothing to complain about.
As we shall see, however, it is virtually inconceivable that shareholders would be able to win a share of the rents in a competitive market. Shareholder returns, therefore, must be the result of a non-competitive process that cannot be legitimated by market claims.
33. See, e.g., KRAAKMAN ET AL., supra note 1, at 114-18 (describing the largely procedural approach of fiduciary duty law). Even the leading case finding liability follows this procedural approach of never suggesting a limit on the right of a fully informed board to operate the corporation in the interests of any party it chooses.
See Van Gorkum, 488 A.2d at 893 (finding uninformed board liable). The RMBCA permits a conflicting interest transaction to stand if it is either approved by a majority of informed, unconflicted directors or shareholders, or it is entirely fair to the corporation. RMBCA § 8.61-.62.
34. Brehm v. Eisner, 746 A.2d 244, 263 n.56 (Del. 2000) (noting that there is a point at which executive compensation becomes actionable waste, but according "great deference" to board judgment because the "size and structure of executive compensation are inherently matters ofjudgment"); In re Walt Disney Co. Derivative Litig., No. CIV.A.15452, 2005 WL 2056651 (Del. Ch. Aug. 9, 2005) (similar proposition).
35. Corporations have been managed with different primary goals in different periods. See, e.g., BERLE &
MEANS, supra note 3, at 67 (discussing instances in which corporations were managed on behalf of the
"control" rather than passive shareholders); JOHN KENNETH GALBRAITH, THE NEW INDUSTRIAL STATE 175, 181, 186, 207, 222 (4th ed. 1985) (1967) (contending that major corporations were, at that time, managed on behalf of the institution's own autonomy-and thus its employees, growth and stability-with little concern for consumers or shareholders). Courts have also declined to intervene when managers have described their goals as furthering the interests of the product or even particular ways of doing business, rather than any human party.
See, e.g., Paramount Commc'ns, Inc. v. Time Inc., 571 A.2d 1140, 1144 n.4 (Del. 1989) (stating that outside directors sought to run corporation in order best to protect "Time Culture"); Cheff v. Mathes, 199 A.2d 548 (Del. 1964) (appearing to approve company's dedication to a particular sales method).
36. Even Lynn Stout, who has questioned most aspects of the shareholder-primacy model in the course of de-essentializing the fictional shareholder, continues to assume that ultimately the goal of every corporation should be to make money for shareholders. See, e.g., Lynn A. Stout, Bad and Not-So-Bad Arguments For Shareholder Primacy, 75 S. CAL. L. REV. 1189 (2002). For a recent survey of the remarkable consensus in favor of the shareholder-centric model of the corporation, see Ronald Chen & Jon Hanson, The Illusion of Law: The Legitimating Schemas of Modern Policy and Corporate Law, 103 MICH. L. REV. 1, 39-41 (2004).
Shareholders are not entitled to profits by law. They are not entitled to them by economic right. Are they entitled to them at all?
III. THE MARKET MODEL: THE DIVIDEND MYSTERY
In standard nexus of contract and most other economically oriented models,37 shareholders are viewed as a factor of production like all other factors of production in the firm.38 Firms need capital (among other things) in order to produce their product, and they purchase or rent that capital in the capital markets.39 Roughly speaking, they purchase capital by selling stock; they rent it by issuing debt.
37. Modem economically oriented models of the corporation come in a wide variety of forms. Classic models took the firm as a "black box," treating it as if it were a single producer without investigating its internal dynamics. Coase argued that this obfuscated the issue of why firms exist in the first place, which he contended could only be due to an efficiency advantage resulting from eliminating the market's pricing mechanism internally. Firms, thus, should exist where the market generates poor results and administration ("fiat" in his terms) can generate better ones. R.H. Coase, The Nature of the Firm, 4 ECONOMICA 386 (1937), reprinted in R.H. COASE, THE FIRM, THE MARKET AND THE LAW 33-57 (1988), and in THE NATURE OF THE FIRM: ORIGINS, EVOLUTION, AND DEVELOPMENT 18-33 (Oliver E. Williamson & Sidney G. Winter eds., 1991).
Theorists have since developed Coase's insight in several different directions. Institutional economics focuses on the internal dynamics of the firm. Williamson's transaction cost economics focuses particularly on the microeconomics of contract failure that might lead to firms. See generally OLIVER WILLIAMSON, THE NATURE OF THE FIRM (1991); WILLIAMSON, supra note 4. Hansmann has used a similar approach to explore corporate governance and, importantly for this Article's analysis, distribution of ownership rights in the firm.
See generally HANSMANN, supra note 4. More recently, Blair & Stout have emphasized the role of the corporation as a "mediating hierarchy" in resolving such problems of team production, and Stout has begun to consider the implications of abandoning the fiction that shareholders have a single and uniform interest. Blair &
Stout, supra note 4; Lynn Stout & Margaret Blair, Specific Investment: Explaining Anomalies in Corporate Law, 31 J. CORP. L. 719 (2006); see also Daniel J.H. Greenwood, Fictional Shareholders: For Whom are
Corporate Managers Trustees, Revisited, 69 S. CAL. L. REV. 1021 (1996) (arguing that the fiction of a unified shareholder interest serves as an ideological justification for lack of corporate democracy). Others, such as Alchian & Demsetz, supra note 1, and Jensen & Meckling, supra note 1, and their followers, have gone in the opposite direction, treating the firm itself as no more than a moment in the market, a nexus of contracts understandable without any need to refer to the institution itself. This approach was early-on critiqued for its mystification by Arthur Left and Bill Bratton, supra note 1, but nevertheless its market reductionism proved quite popular, reaching its quintessence in books by Roberta Romano and Easterbrook & Fischel. See generally, FRANK EASTERBROOK & DANIEL FISCHEL, THE ECONOMIC STRUCTURE OF CORPORATE LAW (1991); ROBERTA ROMANO, THE GENIUS OF AMERICAN CORPORATE LAW (1993). Recent market-based theories have sought to apply the insights of sophisticated behavioral finance theorists such as Andrei Shleifer to model the behavior of shareholders, thought of primarily as participants in a finance market rather than "owners" of a company.
Communitarians, including Larry Mitchell, have emphasized the importance of trust and its social bases, often assumed and therefore neglected in older economic models. See, e.g., Lawrence Mitchell, The Importance of Being Trusted, 81 B.U. L. REV. 591 (2001). Mark Roe has usefully emphasized that efficiency considerations always exist within a particular political framework, so that market evolution may lead to different results in different contexts. See generally MARK ROE, STRONG MANAGERS, WEAK OWNERS: THE POLITICAL ROOTS OF AMERICAN CORPORATE FINANCE (1994).
38. HANSMANN, supra note 4, at 12-16 (treating firm as a capital cooperative). This Article maybe seen as a claim that the market problems identified by Williamson and Hansmann as reasons for the firm structure we see-principally, lock-in, asymmetric information and marginal/average cost difference problems-have not, in fact, been solved by the existing legal structures.
39. See, e.g., BREALEY ET AL., supra note 2, at 445 (describing the full interchangeability of debt and equity financing under Miller and Modigliani's proposition 1, and partial interchangeability under competing theories).
Treating the stockholders as a factor of production that has sold capital to the firm has the heuristic advantage of emphasizing that, from the firm's perspective, the capital market is a market like all others, in which an array of commodities is for sale or rent at a variety of market-determined prices. Here, as in any competitive commodity market, a purchaser (i.e., the firm) has no reason to pay anything more than the competitive price, and that should equal its marginal cost of production. Thus, we can state the puzzle:
Shareholders are perfectly fungible providers of the most perfectly fungible of commodities (cash and some risk-bearing services), in our most competitive of markets. A priori, then, one would expect that they would receive no more than the market price for their product, which should equal its marginal cost of production.
If so, it is surprising to find that shareholders expect to share in any excess returns the firm may obtain. Rather, one would expect that any disequilibrium or monopoly firm profits would be retained by the firm itself or go to a firm participant with disequilibrium or monopoly power. Public shareholders-because they are fully fungible providers of a fully fungible commodity in a highly competitive market-are the least likely firm participants to have that kind of power.
Bond holders and bank lenders are in fact paid precisely in this manner: they receive a fee that is closely related to the general cost of producing money (i.e., general interest rates), adjusted to reflect the expected risk of the particular firm. They do not expect to participate in extraordinary firm earnings, except perhaps to the extent that such earnings reduce risk for which the creditors have already been compensated. But equity is harder to understand.
A. Full Competitive Equilibrium
First, some background. Under standard economic models, a firm selling a commodity product in a fully competitive equilibrium market must sell its product at a price equal to the marginal cost of production of the lowest-cost firm. If it sets its price any higher, customers will purchase from a competitor and it will fail. This is normally expressed in standard black box models by stating that a firm in fully competitive markets earns no economic profit.
At equilibrium there can be no internal distribution issues within the firm. Each factor of production must be paid no more than its lowest cost on the market. If any factor of production were to successfully demand more than its replacement cost, it would, parasite-like, kill its host. The firm would have higher costs of production than its competitors and be unable to compete.
Capital is no different than labor or raw materials in this model. It must be paid the lowest possible amount necessary to generate the minimum capital required to run the company-that is, capital may be paid no more than its cost of production in a competitive market. If it is paid more than that, the firm's costs will be higher than its competitors and it will be unable to price its product competitively, leading to failure.
Actually, shareholders should expect even less. In competitive markets, prices normally adjust to marginal cost. Equity capital usually will be a sunk cost with a
